Competitiveness Means Less Government, Not More

About the Author

The Bush Administration
has proposed the Amer­ican Competitiveness Initiative, a $5.9
billion pro­gram ostensibly designed to "strengthen our
nation's ability to compete in the global economy."[1] Key fea­tures
include more money for federal research pro­grams and new
subsidies for mathematics and science teachers.

The American
Competitiveness Initiative is the wrong solution in response to a
flawed diagnosis. The United States is one of the world's most
com­petitive economies, according to a wide variety of
independent rankings. This lofty status is largely due to the fact
that its government is comparatively small and markets are allowed
to operate without crippling levels of intervention and regulation.
Yet the Administration has arrived at the rather puz­zling
conclusion that expanding the size and bur­den of federal
spending is a recipe for enhanced competitiveness.

If politicians increase
the size and scope of gov­ernment, America's economy will
suffer and its rela­tive competitiveness ranking will decline,
assuming that other nations avoid similar mistakes. This is because
government spending misallocates an econ­omy's labor and
capital, regardless of whether it is financed by taxes or by
borrowing.[2] However, if pol­icymakers reduce
government spending, lower tax rates, break up the government
school monopoly, and take other steps to liberalize the economy,
America's competitive position will improve.

Competitiveness and
Government Policy

The United States is a rich nation, with
broadly shared wealth and prosperity. Property rights, the rule of
law, stable money, and a modest level of gov­ernment combine to
create an environment that is conducive to work, saving,
investment, risk-taking, and entrepreneurship. Ideally, government
policy should facilitate these types of productive behavior,
thereby enabling higher living standards.

Competitiveness is the
result of many factors, including trade policy, health care policy,
fiscal pol­icy, labor policy, regulatory policy, legal policy,
and monetary policy.[3] This short paper will not attempt a
comprehensive analysis, but instead will present data on America's
competitive position, highlight an area-corporate taxation-where
policymakers can improve competitiveness, and then explain why the
American Competitiveness Initiative's emphasis on more federal
education spending is misguided.

A key finding is that
America does well in overall rankings, but certain reforms could
improve com­petitiveness. For instance, America's corporate tax
rate is very high by global standards, and reducing it would
improve U.S. competitiveness and boost economic performance.
America is also one of the few nations that double-taxes corporate
income earned in other nations, thus exacerbating the damage caused
by high marginal tax rates.

Another conclusion is
that the White House is correct to link competitiveness and
education, but the assumption that more tax dollars will boost
educational performance is dubious, particularly considering the
federal government's poor track record. Instead of focusing on the
amount of money expended, policymakers should turn their attention
to how the money is spent. America spends more per pupil than
almost any other nation, yet educational outcomes are mediocre at
best. Educational choice is a much better way to boost performance,
though state and local govern­ments rather than politicians in
Washington should be the ones to liberalize the system.

Globalization has made
reducing the burden of government critically important. Jobs and
capital are now much more likely to migrate across national
borders, and nations with lower taxes and less government are the
ones reaping the benefits. This means that the rewards for good
policy are greater than ever before, but the penalties for bad
policy are equally large.

America's Competitive
Ranking

America is one of the
world's richest and freest economies. To some extent, this lofty
position is due to other nations' mistakes. Few nations have the
right institutions, such as rule of law, stable money, and property
rights. Even fewer have the right policies, such as low taxes, open
markets, and modest levels of government.

A number of
international rankings measure or reflect competitiveness. The
United States scores among the top 10 in all nine of these
rankings. Indeed, America is the only nation that is in the top 10
of every ranking. These rankings are not the ultimate arbiter of
global competitiveness, but they surely indicate a country's
relative position.

A review of the
rankings shows a clear pattern. The nations that appear most
frequently have low levels of taxes, spending, and regulation. The
United States is on top (9 of 9), but the other nations that show
up most frequently-Sin­gapore (7), Australia (7), Switzerland
(6), Den­mark (6), Hong Kong (5), Ireland (5) and the United
Kingdom (5)-are generally considered among the world's most
market-oriented jurisdic­tions. (See Table 1.) To maintain its
competitive position, especially as other nations liberalize, the
United States should seek ways to encourage productive behavior by
reducing the burden of government.

Note: Data for Japan, Greece, and Poland were constructed using
some 2004 data if 2005 data were not available.Source: Chris Atkins
and Scott Hodge, "The U.S. Corporate Income Tax System: Once a
World Leader, Now a Millstone Around the Neck of American
Business," Tax Foundation Special Report No. 136, November 2005, at
http://www.taxfoundation.org/files/f6c39320f8909945da06abb30f781a58.pdf
(April 6, 2006).

Fixing the Tax Code to
Boost Competitiveness

Of the many government
policies that influence national competitiveness, taxes are one of
the most important. America's overall tax burden is low compared to
Europe's. This is good news and helps to explain why the U.S.
economy grows faster and creates more jobs than the German and
French economies.

This does not mean that
America has an advan­tage in all areas, however. For instance,
the United States has one of the highest corporate income tax rates
in the industrialized world. The federal gov­ernment imposes a
corporate income tax rate of 35 percent, and state corporate tax
burdens increase the effective tax rate to 40 percent. According to
the Tax Foundation, this is the highest corporate tax burden of any
developed nation.[4]

America has fallen
behind because many other nations-particularly in Europe-have
dramati­cally lowered their corporate tax rates in the past 15
years. This vigorous tax competition has led to bet­ter tax
policy. Perhaps the most spectacular exam­ple is Ireland, which
lowered its corporate rate from 50 percent to just 12.5 percent. It
is no coinci­dence that Irish living standards and
competitiveness skyrocketed following these reforms.

As the Tax Foundation
study illustrates, many other nations have likewise reduced
corporate tax rates to help their companies compete in the global
economy. Slovakia's tax rate on corporate income is 19 percent.
Iceland has an 18 percent tax rate on business income, and Hungary
imposes a 16 percent tax rate. Even welfare-state nations like
France and Sweden have lower corporate tax rates than
America.

Adding insult to
injury, American-based compa­nies are taxed on their worldwide
income.[5] This policy is very anti-competitive,
subjecting U.S. companies that compete in global markets to higher
tax rates than those paid by companies based in other
nations.

For example, an
American-based company oper­ating in Ireland is at a
disadvantage because its profits are subject to the 35 percent
federal U.S. corporate income tax in addition to Ireland's 12.5
percent corporate tax. The U.S. company generally can claim a
credit for taxes paid to Ireland, so the overall tax rate on
Irish-source income theoretically should not exceed 35
percent.

As Table 2 indicates,
however, this still means that the U.S. firm pays nearly three
times as much tax as an Irish company pays. It also means that the
U.S. firm pays nearly three times as much tax as a Dutch firm
competing in Ireland pays, since the Netherlands has a territorial
tax system. Further­more, these foreign tax credits are not
always avail­able because they can expire or be limited by
other factors.

Source: Author's calculations.

Making matters worse,
the tax code contains a plethora of rules that impose heavy
compliance costs on U.S.-based multinationals. For instance, tax
rules for using foreign tax credits are so onerous that the
effective tax rate on foreign-source income is even higher than the
U.S. corporate rate. Compa­nies are also forced to misallocate
certain expenses to increase taxable income
artificially.

Even features designed
to mitigate the anti-com­petitive nature of worldwide
taxation-such as deferral-are subject to a multiplicity of
restric­tions.[6] Worldwide taxation means that U.S.-based
companies are not allowed to compete on a level playing field. Most
nations do not tax companies on their worldwide income. This means
that com­panies based in those nations can take full
advan­tage of the low corporate tax rates that now exist in so
many countries.[7]

America's high
corporate tax rate and worldwide tax system should be fixed to
improve competitive­ness. The corporate tax rate should be
reduced to 20 percent,[8] and worldwide taxation should be replaced
by territorial taxation-the common-sense notion of taxing only
income earned inside national borders.[9]

The President proposes
to spend more money on research and education as part of his
Competitive­ness Initiative, but this approach is misguided.
More spending has not proven to raise educational achievement. To
improve competitiveness, America needs competition in its K-12
educational system. In other words, the problem is the structure of
the education system, not the amount of money being
spent.

Government-run schools
have not pro­vided good value for taxpayers. The fed­eral
government's involvement has been particularly ill-fated.[10] As
Chart 2 illus­trates, education spending in the United States
has increased dramatically since 1970, yet educational output has
remained flat.

The ambiguous
relationship between government spending and educational
performance is confirmed by global evi­dence. The international
data in Chart 3 show no relationship between the amount of money
spent and the quality of education delivered.

While America's K-12
educational sys­tem has a mediocre track record, Amer­ica's
universities are much more competitive-at least relatively
speaking. TheTimes of London publishes the
best-known international ranking, and Amer­ican universities
hold seven of the top 10 slots and 12 of the top 20 slots. (See
Table 3.)

Competition is one of
the reasons that American universities are so well regarded,
particularly when compared to K-12 education. Students are not
required to attend a college based on where they live. Universities
therefore have to compete by offering a better product. Even if
government sub­sidies and programs distort the pricing of
higher education,[11] the presence of choice results in a
bet­ter product.

Fortunately, there are
growing signs that policy­makers understand this lesson. Places
like Milwau­kee, Cleveland, and the state of Florida have
implemented successful school choice programs, boosting students'
educational performance and triggering improvements in the public
schools that feel the competition of choice.[12] This should
become the norm rather than the exception, partic­ularly as the
United States becomes a more knowl­edge-based economy. State
and local officials should build on these successes by expanding
competition, and the President could use his "bully pulpit" to
promote these much-needed reforms.

Conclusion

America's economy is
competitive largely because the burden of government is small
relative to the burden of government in other countries, but this
does not mean that policymakers should rest on their laurels. In a
competitive global econ­omy, jobs and capital will migrate to
the jurisdic­tions that are lowering tax rates and improving
the environment for productive economic activity.

This requires the right
diagnosis. Contrary to what some politicians argue, America's
competitive position is not threatened because the federal
gov­ernment is not spending enough. Instead, the problem is
that government is too big. Excessive government necessarily causes
the misallocation of labor and capital, and the high tax rates
needed to finance that level of government will discourage work,
saving, and investment.

Policymakers should
concentrate on reducing the burden of government. The corporate tax
rate would be a good place to start. The U.S. arguably has the
worst system in the industrialized world, both because of the high
tax rate and because of the pernicious policy of worldwide
taxation. Mean­while, rather than increase federal interference
in education, policymakers should concentrate on decentralizing
education and implementing school choice.

Daniel J. Mitchell,
Ph.D., is McKenna Senior Research Fellow in the
Thomas A. Roe Institute for Eco­nomic Policy Studies at The
Heritage Foundation.

[5]Determining taxable
foreign-source income is complicated. According to the Joint
Committee on Taxation, the tax code has an "extensive set of rules
governing the determination of the source, either U.S. or foreign,
of items of income and the allo­cation and apportionment of
items of expense against such categories of income." See Joint
Committee on Taxation, U.S. Congress, Description and Analysis
of Present-Law Rules Relating to International Taxation, June
28, 1999, at http://www.house.gov/jct/x-40-99.htm (April 6,
2006).

[6]As the Joint Committee
on Taxation explains, "A variety of complex anti-deferral regimes
impose current U.S. tax on income earned by a U.S. person through a
foreign corporation." See ibid.

[7]According to the Joint
Committee on Taxation, "if a source [foreign] country provides low
effective tax rates on manufac­turing income, a taxpayer
resident in a country with a territorial tax system will fully
enjoy the benefits of the lower source-country rate, while a
taxpayer resident in a country with a worldwide tax system
generally will not." See Joint Committee on Taxation, U.S.
Congress, The U.S. International Tax Rules: Background and
Selected Issues Relating to the Competitiveness of U.S. Businesses
Abroad, July 14, 2003, at http://www.house.gov/jct/x-68-03.pdf (April 6,
2006).